I’ve been spending the vast majority of my time working on a number of new investment ideas, but I do find time to catch up on reading the paper. Earlier this week I came across a post on one of the Wall Street Journal blogs that posted a copy of an old letter that Warren Buffett sent to George Young at National Indemnity (a Berkshire owned insurance subsidiary) regarding his thoughts on GEICO.
I’ve written a few posts on Buffett and GEICO, and his history with the company goes back to 1951 when he put 65% of his net worth (at the time around $13,000) into GEICO stock. At that time, a 21 year old Buffett saw the enormous growth potential GEICO had because of the large market it operated in and the fact that GEICO could provide car insurance at a lower cost than any of its competitors.
The two most important factors:
- Low cost provider of a product that competes mainly on price
- Huge addressable market
These two things—combined with good management—contributed to GEICO’s fabulous growth in earning power in the subsequent decades, and its stock price went up over 100 times.
As I’ve stated before, despite the frequent comparisons between Buffett and Graham in his early years, Buffett was in fact much different than Graham. Although Graham bought a controlling stake in GEICO, he rarely made investment decisions based on the factors that Buffett used to put a majority of his capital into GEICO—factors such as management, market share, cost structure, and future growth prospects. As Buffett wrote about in his 1951 writeup of the stock, these qualitative considerations were much more significant to Buffett than price (which although not a Graham asset based bargain, was still attractive at around 8 times earnings).
So the fact that he bought it at 8 times earnings certainly contributed to Buffett doubling his money in the stock in the next year and a half, but the qualitative factors Buffett pointed out were the reasons that the stock was a 100 bagger over the coming decades.
Regarding his early 1950’s purchase, Buffett wrote that he was able to “develop a depth of conviction which I have felt few times since about any security”.
“At the time I felt that GEICO possessed an extraordinary business advantage in a very large industry that was going to continue to grow. Since that time they never have lost that advantage—the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company.”
But fast forward a couple decades—despite its core low cost advantage still intact—the company was struggling because of factors that often ail many insurance operations—focusing on growth more than prudent underwriting. GEICO’s management had been doing a poor job of pricing its product and they were accepting inadequately priced risk.
Buffett often talks about the dubious prospects of investing in turnarounds, but GEICO was one that he thought could in fact turn. Buffett felt that GEICO was the rare exception to his rule because it had a low cost advantage that was still intact, it was just being mitigated because of poor management.
Buffett felt that this could be corrected, and with the right manager—Jack Byrne—this proved to be true. Buffett bought a significant amount of stock in the 70’s, and then bought the rest of the company entirely in the mid 90’s.
Here is one clip from the letter I thought was worth highlighting, as it is a key advantage to consider with other businesses and investment opportunities:
“I have always been attracted to the low cost operator in any business and, when you can find a combination of i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty five years ago when I first became interested in the company, and it still prevails.”
Here is the link to the entire letter that Buffett sent to National Indemnity concerning his thoughts on GEICO.